Economics 101

(Originally published February 27th, 2012)

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us. The computer? The Internet? The cell phone? The car? The jumbo jet? Television? Air conditioning? The automatic dishwasher? No. Amazingly, economists did not invent any of these brilliant inventions. And economists didn’t predict any of these inventions. Not a one. Despite how brilliant they are. Well, brilliant by their standard. In their particular field. For economists really aren’t that smart. Their ‘expertise’ is in the realm of the social sciences. The faux sciences where people try to quantify the unquantifiable. Using mathematical equations to explain and predict human behavior. Which is what economists do. Especially Keynesian economists. Who think they are smarter than people. And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity. The Austrian school. Where Austrian economics began. In Vienna. Where the great Austrian economists gathered. Carl Menger. Ludwig von Mises. And Friedrich Hayek. To name a few. Who understood that economics is the sum total of millions of people making individual human decisions. Human being key. And why we can’t reduce economics down to a set of mathematical equations. Because you can’t quantify human behavior. Contrary to what the Keynesians believe. Which is why these two schools are at odds with each other. With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school. Because it calls for the government to interfere with market forces. To manipulate them. To make markets produce different results from those they would have if left alone. Something governments love to do. Especially if it calls for taxing and spending. Which Keynesian economics highly encourage. To fix market ‘failures’. And recessions. By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire. They believe more in the separation of the government from things economic. Economic exchanges are best left to the invisible hand. What Adam Smith called the sum total of the millions of human decisions made by millions of people. Who are maximizing their own economic well being. And when we do we maximize the economic well being of the economy as a whole. For the Austrian economist does not believe he or she is smarter than people. Or markets. Which is why an economist never gave us any brilliant invention. Nor did their equations predict any inventor inventing a great invention. And why economists have day jobs. For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs. When they’re able to do that we should start listening to them. But not before.

Keynesian economics really took off with central banking. And fractional reserve banking. Monetary tools to control the money supply. That in the Keynesian world was supposed to end business cycles and recessions as we knew them. The Austrian school argues that using these monetary tools only distorts the business cycle. And makes recessions worse. Here’s how it works. The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money). Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc. This new economic activity encourages businesses to hire new workers to meet the new demand. Ergo, recession over. Simple math, right? Only there’s a bit of a problem. Some of our worst recessions have come during the era of Keynesian economics. Including the worst recession of all time. The Great Depression. Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse. (Economists debate the causes of the Great Depression to this day. Understanding the causes is not the point here. The point is that it happened. When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions. They’re artificial ones. Created by cheap credit. Which the central bank creates by forcing interest rates below actual market interest rates. Which causes a whole host of problems. In particular corrupting the banking system. Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now. This is where savings (or investment capital) come from. Banks pay depositors interest on their deposits. And then loan out this money to others who need investment capital to start businesses. To expand businesses. To buy businesses. Whatever. They borrow money to invest so they can expand economic activity. And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply. Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later). So they borrow to expand operations. All because of the false signal of the artificially low interest rates. They borrow money. Over-invest. And make bad investments. Even speculate. What Austrians call malinvestments. But there was no shift from consumption to investment. Savings haven’t increased. In fact, with all those new loans on the books the banks see a shift in the other direction. Because they have loaned out more money while the savings rate of their depositors did not change. Which produced on their books a reduction in the net savings rate. Leaving them more dangerously leveraged than before the credit expansion. Also, those lower interest rates also decrease the interest rate on savings accounts. Discouraging people from saving their money. Which further reduces the savings rate of depositors. Finally, those lower interest rates reduce the income stream on their loans. Leaving them even more dangerously leveraged. Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation. Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.). This alters the natural order of things. The automatic pricing mechanism of the free market. And reallocates resources to these higher prices. Away from where the market would have otherwise directed them. Creating great shortages and high prices in some areas. And great surpluses of stuff no one wants to buy at any price in other areas. Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap. (But not quite that bad.) Then comes the day when all those investments don’t produce any returns. Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it. They drove up prices. Created great asset bubbles. Overbuilt their capacity. Bought assets at such high prices that they’ll never realize a gain from them. They know what’s coming next. And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning. By keeping interest rates low. But that only allows asset bubbles to get bigger. Making the inevitable correction more painful. But eventually the central bank has to step in and raise interest rates. Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level. And sparks off some nasty inflation. So rates go up. Credit becomes more expensive. Often leaving businesses and speculators to try and refinance bad debt at higher rates. Debt that has no income stream to pay for it. Either forcing business to cut costs elsewhere. Or file bankruptcy. Which ripples through the banking system. Causing a lot of those highly leveraged banks to fail with them. Thus making the resulting recession far more painful and more long-lasting than necessary. Thanks to Keynesian economics. At least, according to the Austrian school. And much of the last century of history.

The Austrian school believes the market should determine interest rates. Not central bankers. They’re not big fans of fractional reserve banking, either. Which only empowers central bankers to cause all of their mischief. Which is why Keynesians don’t like Austrians. Because Keynesians, and politicians, like that power. For they believe that they are smarter than the people making economic exchanges. Smarter than the market. And they just love having control over all of that money. Which comes in pretty handy when playing politics. Which is ultimately the goal of Keynesian economics. Whereas the Austrian school is more about economics.

History 101

(Originally published August 28th, 2012)

Ben Franklin’s Post Office struggles to Stay Relevant in a World where Technology offers a Better Alternative

Once upon a time people stayed in touch with each other by mailing letters to each other. Benjamin Franklin helped make this possible when he was America’s first Postmaster General of the United States. And it’s in large part due to his Post Office that the American Revolutionary War became a united stand against Great Britain. As news of what happened in Massachusetts spread throughout the colonies via Franklin’s Post Office.

In America Samuel Morse created a faster way to communicate. (While others created this technology independently elsewhere.) Through ‘dots’ and ‘dashes’ sent over a telegraph wire. Speeding up communications from days to seconds. It was fast. But you needed people who understood Morse code. Those dots and dashes that represented letters. At both ends of that telegraph wire. So the telegraph was a bit too complicated for the family home. Who still relied on the Post Office to stay in touch

Then along came a guy by the name of Alexander Graham Bell. Who gave us a telephone in the house. Which gave people the speed of the telegraph. But with the simplicity of having a conversation. Bringing many a teenage girl into the kitchen in the evenings to talk to her friends. Until she got her own telephone in her bedroom. Then came cell phones. Email. Smartphones. And Texting. Communication had become so instantaneous today that no one writes letters anymore. And Ben Franklin’s Post Office struggles to stay relevant in a world where technology offers a better alternative.

As Keynesian Monetary Policy played a Larger Role in Japan Personal Savings Fell

These technological advances happened because people saved money that allowed entrepreneurs, investors and businesses to borrow it. They borrowed money and invested it into their businesses. To bring their ideas to the market place. And the more they invested the more they advanced technology. Allowing them to create more incredible things. And to make them more efficiently. Thus giving us a variety of new things at low prices. Thanks to innovation. Risk-taking entrepreneurs. And people’s savings. Which give us an advanced economy. High productivity. And growing GDP.

Following World War II Japan rebuilt her industry and became an advanced economy. As the U.S. auto industry faltered during the Seventies they left the door open for Japan. Who entered. In a big way. They built cars so well that one day they would sell more of them than General Motors. Which is incredible considering the B-29 bomber. That laid waste to Japanese industry during World War II. So how did they recover so fast? A high savings rate. During the Seventies the Japanese people saved over 15% of their income with it peaking in the mid-Seventies close to 25%.

This high savings rate provided enormous amounts of investment capital. Which the Japanese used not only to rebuild their industry but to increase their productivity. Producing one of the world’s greatest export economies. The ‘Made in Japan’ label became increasingly common in the United States. And the world. Their economic clot grew in the Eighties. They began buying U.S. properties. Americans feared they would one day become a wholly owned subsidiary of some Japanese corporation. Then government intervened. With their Keynesian economics. This booming economic juggernaut became Japan Inc. But as Keynesian monetary policy played a larger role personal savings fell. During the Eighties they fell below 15%. And they would continue to fall. As did her economic activity. When monetary credit replaced personal savings for investment capital it only created large asset bubbles. Which popped in the Nineties. Giving the Japanese their Lost Decade. A painful deflationary decade as asset prices returned to market prices.

Because the Germans have been so Responsible in their Economic Policies only they can Save the Eurozone

As the world reels from the fallout of the Great Recession the US, UK and Japan share a lot in common. Depressed economies. Deficit spending. High debt. And a low savings rate. Two countries in the European Union suffer similar economic problems. With one notable exception. They have a higher savings rate. Those two countries are France and Germany. Two of the strongest countries in the Eurozone. And the two that are expected to bail out the Eurozone.

While the French and the Germans are saving their money the Japanese have lost their way when it comes to saving. Their savings rate plummeted following their Lost Decade. As Keynesian economics sat in the driver seat. Replacing personal savings with cheap state credit. Much like it has in the US and the UK. Nations with weak economies and low savings rates. While the French and the Germans are keeping the Euro alive. Especially the Germans. Who are much less Keynesian in their economics. And prefer a more Benjamin Franklin frugality when it comes to cheap state credit. As well as state spending. Who are trying to impose some austerity on the spendthrifts in the Eurozone. Which the spendthrifts resent. But they need money. And the most responsible country in the Eurozone has it. And there is a reason they have it. Because their economic policies have been proven to be the best policies.

And others agree. In fact there are some who want the German taxpayer to save the Euro by taking on the debt of the more irresponsible members in the Eurozone. Because they have been so responsible in their economic policies they’re the only ones who can. But if the Germans are the strongest economy shouldn’t others adopt their policies? Instead of Germany enabling further irresponsible government spending by transferring the debt of the spendthrifts to the German taxpayer? I think the German taxpayer would agree. As would Benjamin Franklin. Who said, “Industry, Perseverance, & Frugality, make Fortune yield.” Which worked in early America. In Japan before Japan Inc. And is currently working in Germany. It’s only when state spending becomes less frugal that states have sovereign debt crises. Or subprime mortgage crisis. Or Lost Decades.

Economics 101

Entrepreneurs turn to Venture Capitalists because they Need a Lot of Money Fast

It takes money to make money. Anyone who ever started a business knows this only too well. For starting a money-making business takes money. A lot of it. New business owners will use their lifesavings. Mortgage their home. Borrow from their parents. Or if they have a really good business plan and own a house with a lot of equity built up in it they may be able to get a loan from a bank. Or find a cosigner who is willing to pledge some collateral to secure a loan.

Once the business is up and running they depend on business profits to pay the bills. And service their debt. If the business struggles they turn to other sources of financing. They pay their bills slower. They use credit cards. They draw down their line of credit at their bank. They go back to a parent and borrow more money. A lot of businesses fail at this point. But some survive. And their profits not only pay their bills and service their debt. But these profits can sustain growth.

This is one path. Entrepreneurs with a brilliant new invention may need a lot of money fast. To pay for land, a large building for manufacturing, equipment and tooling, energy, waste disposal, packaging, distribution and sales. And all the people in production and management. This is just too much money for someone’s lifesavings or a home mortgage to pay for. So they turn to venture capital. Investors who will take a huge risk and pay these costs in return for a share of the profits. And the huge windfall when taking the company public. If the company doesn’t fail before going public.

The Common Stockholders take the Biggest Risk of All who Finance a Business

As a company grows they need more financing. And they turn to the capital markets. To issue bonds. A large loan broken up into smaller pieces that many bond purchasers can buy. Each bond paying a fixed interest rate in return for these buyers (i.e., creditors) taking a risk. Businesses have to redeem their bonds one day (i.e., repay this loan). Which they don’t have to do with stocks. The other way businesses raise money in the capital markets. When owners take their business public they are selling it to investors. This initial public offering (IPO) of stock brings in money to the business that they don’t have to pay back. What they give up for this wealth of funding is some control of their business. The investors who buy this stock get dividends (similar to interest) and voting rights in exchange for taking this risk. And the chance to reap huge capital gains.

The common stockholders take the biggest risk in financing a business. (Preferred stockholders fall between bondholders and common stockholders in terms of risk, get a fixed dividend but no voting rights.) In exchange for that risk they get voting rights. They elect the board of directors. Who hire the company’s officers. So they have the largest say in how the business does its business. Because they have the largest stake in the company. After all, they own it. Which is why businesses work hard to please their common stockholders. For if they don’t they can lose their job.

During profitable times the board of directors may vote to increase the dividend on the common stock. But if the business is not doing well they may vote to reduce the dividend. Or suspend it entirely. What will worry stockholders, though, more than a reduced dividend is a falling stock price. For stockholders make a lot of money by buying and selling their shares of stock. And if the price of their stock falls while they’re holding it they will not be able to sell it without taking a loss on their investment. So a reduced dividend may be the least of their worries. As they are far more concerned about what is causing the value of their stock to fall.

Investors make Money by Buying and Selling Stocks based on this Simple Adage, “Buy Low, Sell High.”

A business only gets money from investors from the IPO. Once investors buy this stock they can sell it in the secondary market. This is what drives the Dow Jones Industrial Average. This buying and selling of stocks between investors on the secondary market. A business gets no additional funding from these transactions. But they watch the price of their stock very closely. For it can affect their ability to get new financing. Creditors don’t want to take all of the risk. Neither do investors. They want to see a mix of debt (bonds) and equity (stocks). And if the stock price falls it will be difficult for them to raise money by issuing more stock. Forcing them to issue more bonds. Increasing the risk of the creditors. Which raises the bond interest rate they must pay to attract creditors. Which makes it hard for the business to raise money to finance operations when their stock price falls. Not to mention putting the jobs of executive management at risk.

Why? Because this is not why venture capitalists risk their money. It is not why investors buy stock in an IPO. They take these great risks to make money. Not to lose money. And the way they expect to get rich is with a rising stock price. Business owners and their early financers get a share of the stock at the IPO. For their risk-taking. And the higher the stock trades for after the IPO the richer they get. When the stock price settles down after a meteoric rise following the IPO the entrepreneurs and their venture capitalists can sell their stock at the prevailing market price and become incredibly rich. Thanks to a huge capital gain in the price of the stock. At least, that is the plan.

But what causes this huge capital gain? The expectations of future profitability of the new public company. It’s not about what it is doing today. But what investors think they will be doing tomorrow. If they believe that their new product will be the next thing everyone must have investors will want to own that stock before everyone starts buying those things. So they can take that meteoric rise along with the stock price. As this new product produces record profits for this business. So everyone will bid up the price because the investors must have this stock. Just as they are sure consumers will feel they must have what this business sells. When there are a lot of companies competing in the same technology market all of these tech stock prices can rise to great heights. As everyone is taking a big bet that the company they’re buying into will make that next big thing everyone must have. Causing these stocks to become overvalued. As these investors’ enthusiasm gets the better of them. And when reality sets in it can be devastating.

Investors make money by buying and selling stocks. The key to making wealth is this simple adage, “Buy low, sell high.” Which means you don’t want to be holding a stock when its price is falling. So what is an investor to do? Sell when it could only be a momentary correction before continuing its meteoric rise? Missing out on a huge capital gain? Or hold on to it waiting for it to continue its meteoric rise? Only to see the bottom fall out causing a great financial loss? The kind of loss that has made investors jump out of a window? Tough decision. With painful consequences if an investor decides wrong. Sometimes it’s just not one individual investor. If a group of stocks are overvalued. If there is a bubble in the stock market. And it bursts. Look out. The losses will be huge as many overvalued stocks come crashing down. Causing a stock market crash. A recession. A Great Recession. Even a Great Depression.

History 101

When a Factor advanced their Money to a Planter it could take up to 9 Months or more to Get it Back

It takes money to make money. And in the early days before big banks there were few places to get big amounts of money. Which you needed in the New World to grow large crops like tobacco. You needed big amounts of money because it took a long time from planting a crop to getting it to market in Europe. Planters needed money to plant, grow, harvest, bale, ship to a seaport where it then shipped by sail to a European market. Then money from the eventual sale of that tobacco would take a couple of months to make it back to the planter.

It could take up to 9 months or more before they actually got the proceeds from the crops they grew. And there were no large banks to provide financing for the planters. So what did they do? Enter rich people. And merchant banks. Factors. Who advanced planters money to plant, grow, harvest, bale and ship their crops to a European market. And when they sold those crops and the money worked its way back across the ocean it went to the factors.

But why would rich people do this? Why would they take a risk with their money? When they advanced their money it could take up to 9 months or more before they got it back. A lot could happen in 9 months. A drought could have wiped out their crop. Insect infestation could have eaten their crop. Fire could have destroyed the crop as it made its way to an ocean going sailing ship. And that sailing ship could have suffered damage in a storm and sank. So there was a lot of risk these rich people took. So why did they?

Factors bought a Future Crop at a Discount from what they Expected it would Sell For

Well, they could mitigate some of this risk by purchasing marine insurance. To cover the cost of their cargo in the event it was lost at sea. But insurance policies aren’t free. They cost money, too. Not to mention the shipping costs to get these crops to market. Costs that had to come out of those crops. So there are costs. And some work. Back then you didn’t buy insurance or pay for transportation electronically. People went to places and negotiated these things with other people. People who earned wages and didn’t work for free.

Today when someone borrows large sums of money they pay interest. Which helps to offset any costs incurred. And let’s people earn money by loaning money. Which provides an incentive to loan money. Which is the only way people can borrow money. When people are willing to loan it. And people only loan money when it’s worth their while. People save their money in the bank to earn interest. They don’t put it there so others can borrow it for free. But before large banks they needed another way to get money to people who needed it. Which brings us back to those factors.

Factors made their money by discounting. Which is a way of earning interest without charging interest. When you buy a Treasury bill you are acting like a factor. You may pay $970 dollars for a Treasury bill with a face value of $1,000. When you redeem this Treasury bill the government pays you $1,000. Giving you a $30 financial gain. Which works out to an effective interest rate of 3%. People like buying treasury securities because they are backed by the full faith and credit of the United States. So there is little risk. Whereas factors took a huge risk. So they didn’t do it on any promise to pay. They got collateral. They bought a future crop at a discount from what they expected it would sell for. Which became theirs. And when that crop sold they got all the proceeds from that sale. Hopefully they got as much as they thought it would sell for. Or more. But, of course, they took the risk that it might have sold for less.

Accounts Receivable Factoring is a Quick and Easy Way for a Business Owner to Raise Cash

Many small businesses will struggle to grow if they don’t offer credit. Allowing their customers to buy things on account. And then paying for all of their monthly purchases at one time at the end of the month. This convenience encourages repeat customers to buy more. And it allows them to buy things that they can sell later. Like a restaurant owner who buys food from a restaurant supplier. After selling prepared meals in his or her restaurant customers pay them. Which allows the restaurant owner to pay his or her restaurant supplier at the end of the month. A system that works well. And benefits both supplier and customer. That is, as long as people are dining at that restaurant.

But sometimes people stop going to restaurants. And stop buying from other businesses. Making it difficult for these businesses to pay their bills. So they start paying their bills slower. Instead of paying them in full at the end of the month they may take an extra month. Or two. So businesses who sold things on account have a growing list of outstanding invoices. Or accounts receivable (A/R). They print out their A/R aging report and they slowly see their open invoices go from 30 days to 60 days to 90 days. Leaving them short of cash to pay their own bills. And if they already maxed out their credit line they may be unable to borrow money. So what other option do they have? Here’s a hint. Most of their outstanding accounts receivable will eventually become cash. In time. All they need is a way to get someone else to wait for that time to pass.

What they need is a factor. Someone to buy their accounts receivable. Giving them the cash they need. While the factor will then pursue the collection of those outstanding invoices. Most of which the customers will pay. And it’s these invoices a factor will buy at a discount. The small business owner loses some profit but they make up for that by getting the cash they need to pay their bills. Accounts receivable factoring is a quick and easy way for a business owner to raise cash. For unlike a loan there is no review of a company’s assets and liabilities. No collateral to pledge. No financial statement analysis. For the owner is selling an asset. His or her accounts receivable. Which is the only thing a factor looks at. The quality of those receivables. Which they converted into cash. Giving business owners the money they need to get back to the business of making money. Much like those planters did in colonial America.

Economics 101

Someone’s Account Payable is Someone’s Account Receivable

Cash is king in small business. Because without it you can’t make payroll or pay your payroll taxes. As important as cash is, though, many business will never grow until they start offering credit. Trade credit. Selling things on account. Because for those doing repeat business it is just too much of a pain to write a check for every purchase. And it’s just dangerous carrying around that kind of cash. So businesses offer credit to established customers. Those with good credit. And good reputations.

Customers open an account. When they make a purchase they get an invoice generally payable in 30 days. Or some number of days around that. At the end of the month they will receive a statement from their vendor showing all of their open invoices. Which they will compare with their accounting records. By running their accounts payable report. And they will compare the invoices they show outstanding with those on their vendor’s statement. They will resolve any differences. And then write a check for their outstanding invoices.

On the other end of the sale there is an account receivable. For someone’s account payable is someone’s account receivable. A sale that doesn’t bring cash into the business. But a promise to pay cash within a short amount of time. So a business can greatly increase sales by offering trade credit. By being a mini-banker. Their sales revenue will grow. As will their net profit. But not necessarily their cash in the bank. For it will look good on paper. But until they convert those accounts receivable into cash it will only be on paper. And money on paper is just not as good as money in the bank.

When Invoices are Unpaid for 90 Days or More there’s a Good Chance they will Never be Paid

There is a certain euphoria small business owners feel when they see their sales grow. Things are moving in the right direction. All their hard work is paying off. Finally. Some even fantasize about spending some of that money. Such as going out to lunch on Friday instead of brown-bagging it every day of the week. Then some anxiety starts growing. And it comes from their accounts receivables report. When they see that 30 days after those sales come and go. And a lot of those open invoices remain on the report.

The accounts receivable report small business owners review is called an aging report. Because it shows what invoices are current, which are 30 days old, which are 60 days old and which are 90 days or more old. And when invoices are unpaid for 90 days or more there’s a good chance they will never be paid. In fact, once they pass 30 days the chances that their customers won’t pay them grow greater. And this is the source of a small business owner’s anxiety. When he or she sees those invoices move from 30 days to 60 days to 90 days.

Why do some customers pay slower than others? Because they, too, have accounts receivable moving from 30 days to 60 days to 90 days. And if they’re not collecting their money in a timely manner then can’t pay their bills in a timely manner. When the economy slows down you will see a lot of businesses start to pay their bills slower. And as they pay their bills slower businesses collect their money slower. Which forces them to pay their bills slower. Or, worse, borrow money to pay their bills until their customers pay theirs.

To encourage their Customers to Pay their Bills Timely many Businesses will offer Early Payment Discounts

Sales are great. Everything that’s good follows from sales. Sales are the first step in creating cash. And cash is king. But between cash and sales are accounts receivable. Which can make or break any small business. For you can’t often grow sales without extending credit. But if you extend too much credit and/or your customers don’t pay their bills a business owner can lose everything he or she worked for. Because when it comes down to it, sales are great but cash is king.

To encourage their customers to pay their bills timely many businesses will offer early payment discounts. If the customer pays their invoice within 10 days, say, they will get a 2% discount on that invoice. So if they have a $1000 invoice they only have to pay $980. As an owner will trade $20 in profits to speed up their cash collections. And if you look at some numbers you can see why. If they have $150,000 in new sales in one month that 2% discount will cost them $3,000 in profits. Now compare that to the cost of borrowing cash from an 11% credit line to replace the cash they can’t collect from their customers. If they have receivables of $150,000 at 30 days, $300,000 at 60 days and $49,950 at 90+ days the interest cost to borrow money to replace these funds can add up to $3,322.46.

So an early payment discount can equal a business’ borrowing costs. Making it a wash. While offering a huge benefit. Allowing a business to pay their bills. Like payroll. Payroll taxes. And their vendors. For in difficult economic times all businesses have cash problems. And will do almost anything to improve their cash position. And when it comes to paying their bills and they can’t pay them all guess which ones they’re going to pay first? Those that help their cash position. That is, those invoices that offer an early payment discount. Because sales are great. But cash is king.

History 101

Ben Franklin’s Post Office struggles to Stay Relevant in a World where Technology offers a Better Alternative

Once upon a time people stayed in touch with each other by mailing letters to each other. Benjamin Franklin helped make this possible when he was America’s first Postmaster General of the United States. And it’s in large part due to his Post Office that the American Revolutionary War became a united stand against Great Britain. As news of what happened in Massachusetts spread throughout the colonies via Franklin’s Post Office.

In America Samuel Morse created a faster way to communicate. (While others created this technology independently elsewhere.) Through ‘dots’ and ‘dashes’ sent over a telegraph wire. Speeding up communications from days to seconds. It was fast. But you needed people who understood Morse code. Those dots and dashes that represented letters. At both ends of that telegraph wire. So the telegraph was a bit too complicated for the family home. Who still relied on the Post Office to stay in touch

Then along came a guy by the name of Alexander Graham Bell. Who gave us a telephone in the house. Which gave people the speed of the telegraph. But with the simplicity of having a conversation. Bringing many a teenage girl into the kitchen in the evenings to talk to her friends. Until she got her own telephone in her bedroom. Then came cell phones. Email. Smartphones. And Texting. Communication had become so instantaneous today that no one writes letters anymore. And Ben Franklin’s Post Office struggles to stay relevant in a world where technology offers a better alternative.

As Keynesian Monetary Policy played a Larger Role in Japan Personal Savings Fell

These technological advances happened because people saved money that allowed entrepreneurs, investors and businesses to borrow it. They borrowed money and invested it into their businesses. To bring their ideas to the market place. And the more they invested the more they advanced technology. Allowing them to create more incredible things. And to make them more efficiently. Thus giving us a variety of new things at low prices. Thanks to innovation. Risk-taking entrepreneurs. And people’s savings. Which give us an advanced economy. High productivity. And growing GDP.

Following World War II Japan rebuilt her industry and became an advanced economy. As the U.S. auto industry faltered during the Seventies they left the door open for Japan. Who entered. In a big way. They built cars so well that one day they would sell more of them than General Motors. Which is incredible considering the B-29 bomber. That laid waste to Japanese industry during World War II. So how did they recover so fast? A high savings rate. During the Seventies the Japanese people saved over 15% of their income with it peaking in the mid-Seventies close to 25%.

This high savings rate provided enormous amounts of investment capital. Which the Japanese used not only to rebuild their industry but to increase their productivity. Producing one of the world’s greatest export economies. The ‘Made in Japan’ label became increasingly common in the United States. And the world. Their economic clot grew in the Eighties. They began buying U.S. properties. Americans feared they would one day become a wholly owned subsidiary of some Japanese corporation. Then government intervened. With their Keynesian economics. This booming economic juggernaut became Japan Inc. But as Keynesian monetary policy played a larger role personal savings fell. During the Eighties they fell below 15%. And they would continue to fall. As did her economic activity. When monetary credit replaced personal savings for investment capital it only created large asset bubbles. Which popped in the Nineties. Giving the Japanese their Lost Decade. A painful deflationary decade as asset prices returned to market prices.

Because the Germans have been so Responsible in their Economic Policies only they can Save the Eurozone

As the world reels from the fallout of the Great Recession the US, UK and Japan share a lot in common. Depressed economies. Deficit spending. High debt. And a low savings rate. Two countries in the European Union suffer similar economic problems. With one notable exception. They have a higher savings rate. Those two countries are France and Germany. Two of the strongest countries in the Eurozone. And the two that are expected to bail out the Eurozone.

While the French and the Germans are saving their money the Japanese have lost their way when it comes to saving. Their savings rate plummeted following their Lost Decade. As Keynesian economics sat in the driver seat. Replacing personal savings with cheap state credit. Much like it has in the US and the UK. Nations with weak economies and low savings rates. While the French and the Germans are keeping the Euro alive. Especially the Germans. Who are much less Keynesian in their economics. And prefer a more Benjamin Franklin frugality when it comes to cheap state credit. As well as state spending. Who are trying to impose some austerity on the spendthrifts in the Eurozone. Which the spendthrifts resent. But they need money. And the most responsible country in the Eurozone has it. And there is a reason they have it. Because their economic policies have been proven to be the best policies.

And others agree. In fact there are some who want the German taxpayer to save the Euro by taking on the debt of the more irresponsible members in the Eurozone. Because they have been so responsible in their economic policies they’re the only ones who can. But if the Germans are the strongest economy shouldn’t others adopt their policies? Instead of Germany enabling further irresponsible government spending by transferring the debt of the spendthrifts to the German taxpayer? I think the German taxpayer would agree. As would Benjamin Franklin. Who said, “Industry, Perseverance, & Frugality, make Fortune yield.” Which worked in early America. In Japan before Japan Inc. And is currently working in Germany. It’s only when state spending becomes less frugal that states have sovereign debt crises. Or subprime mortgage crisis. Or Lost Decades.

Politics 101

Washington looked upon Hamilton, Madison and Jefferson as the Sons he Never Had

With the new Constitution ratified it was time to put the grand experiment into action. Beginning with America’s first presidential election. And the system we now call the Electoral College. Each state chose their electors. These electors then voted for the president. Even this first act of the new federal government was a safeguard to keep its power limited. (And independent of the Congress.) By keeping the new republican government from becoming a democracy. The mob-rule that was the ruin of republics. By putting intermediaries between the people and the most powerful person in America. The president. To prevent anyone rising to power simply by promising to shower riches on the people from the federal treasury.

George Washington did something no one has done since. He received 100% of the vote. Every elector voted for him for president. Unanimously. John Adams came in second. Each elector had two votes. One to cast for president. The other to cast for vice president. The one with the greatest number of votes was president. The one with the next most votes became vice president. As this was a time before party politics. There were no political parties yet. But there would be. And that would change the way we voted for president.

Both Washington and Adams were Federalists. They both supported the Constitution. And the federal government. As did the other Federalists. Including Alexander Hamilton. Who Washington selected as secretary of the treasury. And would be a major player in the Federalist camp. His fellow Federalist, James Madison, who coauthored the Federalist Papers with Hamilton (and John Jay) won election to the House of Representative. Where he introduced and fought for passage of the Bill of Rights. Thomas Jefferson, author of the Declaration of Independence, was in Europe during the Philadelphia Convention and the ratification process of the Constitution. But he supported it as long as it included a bill of rights. Washington selected Jefferson for his secretary of state. Washington looked upon Hamilton, Madison and Jefferson as the sons he never had. And loved them as sons. But that would change.

Born out of Wedlock Hamilton was Never Accepted by those ‘Better’ than Him

Washington being the first president everything he did set a precedent. And he was very conscious of that. As well as his place in history. For he wanted to be remembered as America’s first president of many to come. Not the man who was at the helm when this experiment in self-government failed. This is why he created a cabinet quickly. Even though the Constitution included nothing about a cabinet. After commanding the Continental Army for 8 years he knew how to give orders and delegate authority. And after battling Congress during those same years he became a good administrator who understood how to compromise. He hated politics. But he understood politics. And knew it meant compromise on the little things. And standing resolute on the bigger things.

Hamilton was Washington’s aide-de-camp during the war. He was smart and understood commerce. During the war he wrote to Congress about the ruinous inflation crippling the economy. And starving the army. Proposing a national bank back then. Washington trusted and respected Hamilton. And valued his counsel. Which is why he made him his secretary of treasury. The country was in a mess. In debt. And it needed a plan to raise revenue. To pay for government. And to service that debt. Even just to understand the debt. For money was owed at every level of government. Which was what prompted the Philadelphia Convention in the first place. To put the nation on a sound footing to move forward. And there wasn’t a better person available than Hamilton. Who remains even today America’s greatest treasury secretary.

Hamilton was brilliant. And he had grand plans for the United States. He saw the potential in the new nation. And he wanted to use the power of government to hurry it along. He was also aggressive. And combative. Born out of wedlock he was never accepted by those ‘better’ than him. So he spent a lifetime fighting this social stigma. Acquiring a competitive nature. Making him unpopular. And obstinate. He fought long and hard for what he wanted. Knowing that he was right. And others were wrong. Even though this may have been true at times it tended to be off-putting. So Hamilton would spend his political career making political enemies. And it started in the Washington administration.

After Hamilton’s Three Reports James Madison parted ways with Hamilton and became an Anti-Federalist

While the Americans were setting up their first national government France was well along the way to the French Revolution. And Thomas Jefferson was there. Returning to the United States the same year of the Tennis Court Oath and the Storming of the Bastille (1789). The French had a taste of liberty from helping the Americans. And now they wanted it, too. France was drowning in debt. A bad growing season caused some famine. The people were restless. Poor. Angry. And sick of the monarchy. Jefferson felt the spirit of ’76 again. He joined the conversations in the clubs where the radicals met. Enjoying their company. Sharing their hate of monarchy. Despite the French Monarchy having financed most of the American Revolution. And provided much of the material to wage war. Didn’t matter. The people’s spirit inflamed him, too. And he brought that spirit home with him. Upon arrival Washington asked him to join his cabinet. He accepted. And the head butting began.

It started with Hamilton’s three reports. The Report on Public Credit (January 1790). The Report on a National Bank (December 1790). And the Report on Manufactures (December 1791). Taken together they kind of looked like a plan to turn the United States into another Great Britain. At least to Jefferson, Madison and anti-Federalists everywhere. What they saw was a nation with lots of debt, where the rich get a little too cozy with the politicians and the financiers reach deep into the halls of government. That wasn’t Hamilton’s intent. Other than wanting to accelerate the Industrial Revolution in American to the level it was in Britain. The subject of his third report. Which was a bit mercantilist in nature like Britain. But the other two were about establishing good credit. To gain the trust of the credit markets. For a country in debt had to be able to borrow money to service that debt. As well as pay for government. Putting the nation on that sound footing to move forward. Which he did. He lowered the per capita debt. And the nation would go on to enjoy a decade of peace and prosperity thanks to his economic policies.

After Hamilton’s three reports came the great schism. James Madison parted ways with Hamilton. Becoming an anti-Federalist. Along with Thomas Jefferson. While still a member of the Federalist administration of George Washington (though he didn’t label himself a Federalist or join in any partisan action). Cabinet meetings became insufferable. As Hamilton and Jefferson just hated each other. Who could only behave in the presence of their ‘father’. George Washington. But the partisan attacks took to the newspapers. Lies and slander flew with regularity. From both directions. Even attacking Washington. Jefferson eventually left the administration but continued his attacks through his surrogate James Madison. The attacks on Washington got so ugly that he never spoke to Jefferson again. Who turned into a radical partisan. Washington was never happier when his second term ended. The new president was John Adams. Federalist. His vice president was Thomas Jefferson. Leader of the anti-Federalists. Who became the new Democrat-Republicans. Which is why they had to change the election process for president. So the president and the vice president belonged to the same political party. So they worked together instead of leading the attack against each other and their party.

History 101

The Gold Exchange Standard provided Stability for International Trade

Congress created the Federal Reserve System (the Fed) with the passage of the Federal Reserve Act in 1913. They created the Fed because of some recent bad depressions and financial panics. Which they were going to make a thing of the past with the Fed. It had three basic responsibilities. Maximize employment. Stabilize prices. And optimize interest rates. With the government managing these things depressions and financial panics weren’t going to happen on the Fed’s watch.

The worst depression and financial panic of all time happened on the Fed’s watch. The Great Depression. From 1930. Until World War II. A lost decade. A period that saw the worst banking crises. And the greatest monetary contraction in U.S. history. And this after passing the Federal Reserve Act to prevent any such things from happening. So why did this happen? Why did a normal recession turn into the Great Depression? Because of government intervention into the economy. Such as the Smoot-Hawley Tariff Act that triggered the great selloff and stock market crash. And some really poor monetary policy. As well as bad fiscal policy.

At the time the U.S. was on a gold exchange standard. Paper currency backed by gold. And exchangeable for gold. The amount of currency in circulation depended upon the amount of gold on deposit. The Federal Reserve Act required a gold reserve for notes in circulation similar to fractional reserve banking. Only instead of keeping paper bills in your vault you had to keep gold. Which provided stability for international trade. But left the domestic money supply, and interest rates, at the whim of the economy. For the only way to lower interest rates to encourage borrowing was to increase the amount of gold on deposit. For with more gold on hand you can increase the money supply. Which lowered interest rates. That encouraged people to borrow money to expand their businesses and buy things. Thus creating economic activity. At least in theory.

The Fed contracted the Money Supply even while there was a Positive Gold Flow into the Country

The gold standard worked well for a century or so. Especially in the era of free trade. Because it moved trade deficits and trade surpluses towards zero. Giving no nation a long-term advantage in trade. Consider two trading partners. One has increasing exports. The other increasing imports. Why? Because the exporter has lower prices than the importer. As goods flow to the importer gold flows to the exporter to pay for those exports. The expansion of the local money supply inflates the local currency and raises prices in the exporter country. Back in the importer country the money supply contracts and lowers prices. So people start buying more from the once importing nation. Thus reversing the flow of goods and gold. These flows reverse over and over keeping the trade deficit (or surplus) trending towards zero. Automatically. With no outside intervention required.

Banknotes in circulation, though, required outside intervention. Because gold isn’t in circulation. So central bankers have to follow some rules to make this function as a gold standard. As gold flows into their country (from having a trade surplus) they have to expand their money supply by putting more bills into circulation. To do what gold did automatically. Increase prices. By maintaining the reserve requirement (by increasing the money supply by the amount the gold deposits increased) they also maintain the fixed exchange rate. An inflow of gold inflates your currency and an outflow of gold deflates your currency. When central banks maintain this mechanism with their monetary policy currencies remain relatively constant in value. Giving no price advantage to any one nation. Thus keeping trade fair.

After the stock market crash in 1929 and the failure of the Bank of the United States in New York failed in 1930 the great monetary contraction began. As more banks failed the money they created via fractional reserve banking disappeared. And the money supply shrank. And what did the Fed do? Increased interest rates. Making it harder than ever to borrow money. And harder than ever for banks to stay in business as businesses couldn’t refinance their loans and defaulted. The Fed did this because it was their professional opinion that sufficient credit was available and that adding liquidity then would only make it harder to do when the markets really needed additional credit. So they contracted the money supply. Even while there was a positive gold flow into the country.

The Gold Standard works Great when all of your Trading Partners use it and they Follow the Rules

Those in the New York Federal Reserve Bank wanted to increase the money supply. The Federal Reserve Board in Washington disagreed. Saying again that sufficient credit was available in the market. Meanwhile people lost faith in the banking system. Rushed to get their money out of their bank before it, too, failed. Causing bank runs. And more bank failures. With these banks went the money they created via fractional reserve banking. Further deflating the money supply. And lowering prices. Which was the wrong thing to happen with a rising gold supply.

Well, that didn’t last. France went on the gold standard with a devalued franc. So they, too, began to accumulate gold. For they wanted to become a great banking center like London and New York. But these gold flows weren’t operating per the rules of a gold exchange. Gold was flowing generally in one direction. To those countries hoarding gold. And countries that were accumulating gold weren’t inflating their money supplies to reverse these flows. So nations began to abandon the gold exchange standard. Britain first. Then every other nation but the U.S.

Now the gold standard works great. But only when all of your trading partners are using it. And they follow the rules. Even during the great contraction of the money supply the Fed raised interest rates to support the gold exchange. Which by then was a lost cause. But they tried to make the dollar strong and appealing to hold. So people would hold dollars instead of their gold. This just further damaged the U.S. economy, though. And further weakened the banking system. While only accelerating the outflow of gold. As nations feared the U.S. would devalue their currency they rushed to exchange their dollars for gold. And did so until FDR abandoned the gold exchange standard, too, in 1933. But it didn’t end the Great Depression. Which had about another decade to go.

Economics 101

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us. The computer? The Internet? The cell phone? The car? The jumbo jet? Television? Air conditioning? The automatic dishwasher? No. Amazingly, economists did not invent any of these brilliant inventions. And economists didn’t predict any of these inventions. Not a one. Despite how brilliant they are. Well, brilliant by their standard. In their particular field. For economists really aren’t that smart. Their ‘expertise’ is in the realm of the social sciences. The faux sciences where people try to quantify the unquantifiable. Using mathematical equations to explain and predict human behavior. Which is what economists do. Especially Keynesian economists. Who think they are smarter than people. And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity. The Austrian school. Where Austrian economics began. In Vienna. Where the great Austrian economists gathered. Carl Menger. Ludwig von Mises. And Friedrich Hayek. To name a few. Who understood that economics is the sum total of millions of people making individual human decisions. Human being key. And why we can’t reduce economics down to a set of mathematical equations. Because you can’t quantify human behavior. Contrary to what the Keynesians believe. Which is why these two schools are at odds with each other. With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school. Because it calls for the government to interfere with market forces. To manipulate them. To make markets produce different results from those they would have if left alone. Something governments love to do. Especially if it calls for taxing and spending. Which Keynesian economics highly encourage. To fix market ‘failures’. And recessions. By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire. They believe more in the separation of the government from things economic. Economic exchanges are best left to the invisible hand. What Adam Smith called the sum total of the millions of human decisions made by millions of people. Who are maximizing their own economic well being. And when we do we maximize the economic well being of the economy as a whole. For the Austrian economist does not believe he or she is smarter than people. Or markets. Which is why an economist never gave us any brilliant invention. Nor did their equations predict any inventor inventing a great invention. And why economists have day jobs. For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs. When they’re able to do that we should start listening to them. But not before.

Keynesian economics really took off with central banking. And fractional reserve banking. Monetary tools to control the money supply. That in the Keynesian world was supposed to end business cycles and recessions as we knew them. The Austrian school argues that using these monetary tools only distorts the business cycle. And makes recessions worse. Here’s how it works. The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money). Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc. This new economic activity encourages businesses to hire new workers to meet the new demand. Ergo, recession over. Simple math, right? Only there’s a bit of a problem. Some of our worst recessions have come during the era of Keynesian economics. Including the worst recession of all time. The Great Depression. Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse. (Economists debate the causes of the Great Depression to this day. Understanding the causes is not the point here. The point is that it happened. When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions. They’re artificial ones. Created by cheap credit. Which the central bank creates by forcing interest rates below actual market interest rates. Which causes a whole host of problems. In particular corrupting the banking system. Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now. This is where savings (or investment capital) come from. Banks pay depositors interest on their deposits. And then loan out this money to others who need investment capital to start businesses. To expand businesses. To buy businesses. Whatever. They borrow money to invest so they can expand economic activity. And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply. Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later). So they borrow to expand operations. All because of the false signal of the artificially low interest rates. They borrow money. Over-invest. And make bad investments. Even speculate. What Austrians call malinvestments. But there was no shift from consumption to investment. Savings haven’t increased. In fact, with all those new loans on the books the banks see a shift in the other direction. Because they have loaned out more money while the savings rate of their depositors did not change. Which produced on their books a reduction in the net savings rate. Leaving them more dangerously leveraged than before the credit expansion. Also, those lower interest rates also decrease the interest rate on savings accounts. Discouraging people from saving their money. Which further reduces the savings rate of depositors. Finally, those lower interest rates reduce the income stream on their loans. Leaving them even more dangerously leveraged. Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation. Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.). This alters the natural order of things. The automatic pricing mechanism of the free market. And reallocates resources to these higher prices. Away from where the market would have otherwise directed them. Creating great shortages and high prices in some areas. And great surpluses of stuff no one wants to buy at any price in other areas. Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap. (But not quite that bad.) Then comes the day when all those investments don’t produce any returns. Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it. They drove up prices. Created great asset bubbles. Overbuilt their capacity. Bought assets at such high prices that they’ll never realize a gain from them. They know what’s coming next. And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning. By keeping interest rates low. But that only allows asset bubbles to get bigger. Making the inevitable correction more painful. But eventually the central bank has to step in and raise interest rates. Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level. And sparks off some nasty inflation. So rates go up. Credit becomes more expensive. Often leaving businesses and speculators to try and refinance bad debt at higher rates. Debt that has no income stream to pay for it. Either forcing business to cut costs elsewhere. Or file bankruptcy. Which ripples through the banking system. Causing a lot of those highly leveraged banks to fail with them. Thus making the resulting recession far more painful and more long-lasting than necessary. Thanks to Keynesian economics. At least, according to the Austrian school. And much of the last century of history.

The Austrian school believes the market should determine interest rates. Not central bankers. They’re not big fans of fractional reserve banking, either. Which only empowers central bankers to cause all of their mischief. Which is why Keynesians don’t like Austrians. Because Keynesians, and politicians, like that power. For they believe that they are smarter than the people making economic exchanges. Smarter than the market. And they just love having control over all of that money. Which comes in pretty handy when playing politics. Which is ultimately the goal of Keynesian economics. Whereas the Austrian school is more about economics.

Economics 101

We note a civilization as being modern when it has vigorous economic activity. Advanced economies around the world all have the same things. Grocery stores. Clothing stores. Electronic stores. Appliance stores. Coffee shops and restaurants. Factories and manufacturing plants. And lots and lots of jobs. Where people are trading their human capital for a paycheck. So they can take their earnings and engage in economic activity at these stores, coffee shops and restaurants.

To buy things off of shelves in these stores things have to be on those shelves first. Which means selling things requires spending money before you earn money. Businesses use trade credit. Such as accounts payable. Where a supplier will give them supplies and send them an invoice typically payable in 30-90 days. They will establish a credit line at their bank. Where they will borrow from when they need cash. And will repay as they collect cash (such as when their customers pay their accounts payable). And take out loans to finance specific things such as a delivery van or restaurant equipment.

Businesses depend on their bank for most of their credit needs. But when companies grow so do their capital requirements. Where capital is large amounts of money pooled together to purchase property, buildings, machinery, etc. Amounts so great that it exceeds a bank’s ability to loan. So these businesses have to turn to other types of financing. To the equity and debt markets.

Investors Invest in Corporations by Buying their Stocks and Bonds

Equity and debt markets mean stocks and bonds. Where we use stocks for equity financing. And bonds for debt financing. Stocks and bonds allow a corporation to spread their large financing needs over numerous people. Investors. Who invest in corporations by buying their stocks and bonds.

When a business ‘goes public’ they are selling stock in their company for the first time. We call this the initial public offering (IPO). If the company has a very promising future this will bring in a windfall of capital. As investors are anxious to get in on the ground floor of the next big thing. To be a part of the next Microsoft. Or Apple. This is when a lot of entrepreneurs get rich. When they are in fact the next big thing. And if they are, then people who bought stock in their IPO can sell it on the secondary market. Where investors trade stocks with other investors. By buying low and selling high. Hopefully. If they do they get rich. Because the greater a company’s profits the greater its value and the higher its stock price. And when a company takes off they can sell their stock at a much higher price than they paid for it in the IPO.

When a corporation needs to borrow more than their bank can loan and doesn’t want to issue new stock they can sell bonds. Which breaks up a very large amount into smaller amounts that investors can buy. Typically each individual corporate bond has a face value of $1000. (So a ten million dollar ‘loan’ would consist of selling ten thousand $1,000 bonds). Like a loan a corporation pays interest on their bonds. But not to a bank. They pay interest to the investors who purchased their bonds. Who can hold the bonds to maturity and collect interest. Or they can trade them like stock shares. (Changes in the interest rates and/or corporate financial strength can change the market value of these bonds.) When a bond reaches maturity (say in 20 years) the company redeems their bonds from the current bondholders. Hopefully with the new profits the bond issue helped to bring into the corporation. Or they just issue new bonds to raise the money to redeem the older bonds.

A Company Usually has a Mix of Equity and Debt Financing that Balances all the Pros and Cons of Each

There are pros and cons to both equity and debt financing. Selling stock transfers ownership of the company. Sell enough so that someone can own more than 50% and that someone can replace the board of directors. Who in turn can replace the CEO and the other corporate officers. Even the business founder. This is the big drawback of going public. Founders can lose control of their company.

Stocks don’t pay interest. So they are less threatening during bad economic times. As business owners, stock shareholders are there for the long haul. During the good times they may expect to collect dividends (like an interest payment). During bad times they will wait it out while the company suspends dividend payments. Or, if they lose confidence, they’ll try and sell their stock. Even at a loss. To prevent a future greater loss. Especially if the corporation goes bankrupt. Because stockholders are last in line during any bankruptcy proceedings. And usually by the time they pay off creditors there is nothing left for the shareholders. This is the price for the chance to earn big profits. The possibility to lose everything they’ve invested.

Bonds are different. First of all, there is no transfer of ownership. But there is a contractual obligation to make scheduled interest payments. And if they fail to make these payments the bondholders can force the company into bankruptcy proceedings. Where a corporation’s assets can be liquidated to pay their creditors. Including their bondholders. Which, of course, often means the end of the corporation. Or a major restructuring that few in management enjoy.

Stockholders don’t like seeing their share value diluted from issuing too many shares. Bondholders don’t like to see excessive debt that threatens the corporation’s ability to service their debt. So a company usually has a mix of equity and debt financing that balances the pros and cons of each. A financing strategy that has been working for centuries. That allows the advanced civilized world we take all too much for granted today. From jetliners. To smartphones. To that new car smell. For none of these would be possible without the capital that only the equity and debt markets can raise.